Time to Go it Alone and Bolt from Basel?

Is the Basel Committee on Banking Supervision building an effective set of capital rules, one that will accomplish the goal of competitive parity?

Or are the rules being drafted by U.S. regulators to implement the Dodd-Frank Act a better way to go? Even if the answer were no, does the U.S. want two sets of capital rules? Our own and Basel's? Does that make sense or is it a case of, as one banker put it, "belts, suspenders and a noose."

These are questions worth asking, particularly as the regulatory agencies struggle under a heavy workload and tight Dodd-Frank deadlines. Karen Shaw Petrou, a prominent policy analyst who has been scrutinizing Basel capital rules since the first one was adopted in the late 1980s, has a provocative suggestion.

"It's time to rethink whether this global process really is the right way to craft a sound regulatory regime for the United States," said Petrou, the managing partner of Federal Financial Analytics. If Basel III has "become a losing game — and we think it has — then the U.S. should cut its losses and bail on Basel and just write the rules that work for us."

Bail on Basel? Admit it: it's a tempting thought.

The main goal of the Basel III capital rules is competitive parity — global banks will all be held to the same standard. But that's not how it's working out.

First, we have Dodd-Frank, which will give the U.S. capital and liquidity rules as well as other limits on operations that stretch way beyond Basel III. Another major banking center, China, isn't even a part of the Basel crowd, and Japan has never given more than lip service to the accords.

But perhaps most dispiriting is what's happening in the European Union. In another set of implementing instructions released July 20, it told member states they must all follow the same approach, which is generally considered lighter and slower than the Basel Committee intended. No EU member country will be allowed to adopt a stiffer set of rules — a decision that has British regulators seeing red.

"The EU is watering it down," said Anat R. Admati, a professor at Stanford University's graduate school of business. "It clips the wings of the U.K. It is a complete intrusion."

Writing rules to implement an international standard seems like a waste of resources considering our Dodd-Frank-frenzied regulators don't have time or people to spare.

"The implementation load is more than the regulators or the banks can handle competently," said Wayne Abernathy, executive vice president of financial institutions policy at the American Bankers Association. "It's time for the policymakers to set priorities. If you are going to put some things on the shelf for a while, Basel is one that I would put on the shelf."

This is not an argument against stronger capital rules. It's an acknowledgment that the U.S. now has a law that mandates not only risk-based capital rules but a host of other regulatory restrictions designed to curb systemic risk and resolve the largest firms if they hit a wall. It's likely, too, that banks here will be held to higher capital ratios sooner than the drawn-out Basel timetable, which stretches to 2019. Remember, in order to pay dividends, the Federal Reserve Board required the giants to prove they could meet Basel minimums by 2013.

This is also not an argument against the guts of Basel III. In fact, the capital rules here are likely to mirror much of what's in the accord. It's just that they will be part of rules the Fed is writing to implement section 165 of Dodd-Frank. This proposal will be out by summer's end, Fed Chairman Ben Bernanke said last week. Sources call it "colossal," running 1,000 pages or more.

Section 165 of Dodd-Frank requires banks with more than $50 billion in assets and any nonbanks deemed systemically important (those designations have not been made yet) to operate under prudential standards that are "more stringent" than the ones applied to smaller, less systemically important companies.

Those are the mandatory elements. The law also gives the Fed the option of writing additional prudential standards on any of these topics: contingent capital; enhanced public disclosures; short-term debt limits; and anything other factors the Fed "determines are appropriate."

With Dodd-Frank, for the first time, our regulatory goals are fundamentally different from the Europeans'.

The reform law declared an end to big-bank bailouts. The law expands the Federal Deposit Insurance Corp.'s capacity for liquidating mega financial firms and it requires key companies to write "living wills" to steer regulators should they have to unwind the firm in a failure. It says the government will not cough up any money to save a financial behemoth and it stripped the regulators of a lot of the tools they have used in the past.

By contrast, many European leaders have conceded their large banks will be saved if for no other reason than their failure would bring down the country's economy.

"You have a global regime premised on rescue and taxpayer resolution," Petrou said. "That's very much baked into the Basel III construct."

What would happen if the U.S. pulled out of Basel III as Petrou suggests? Clearly there is downside risk, including the real possibility the whole process would implode.

But that might give the U.S. some leverage to influence Basel III, both how it is implemented and what elements it contains.

Under Basel III minimums, a company must hold common equity equal to 4.5% of its risk-weighted assets by 2015. A 2.5% conservation buffer will be required by 2019. Basel has also proposed a surcharge for the largest companies. It would range from 1% to 2.5% of a company's risk-weighted assets, depending on a series of "indicators" and "buckets" designed to rank banks by how much risk they pose to the global financial system. (For those without a calculator nearby, that's a total of 8% to 9.5%. Basel III contains a third surcharge of 2% that is designed to smooth economic cycles, but the committee left its adoption to the discretion of national regulators.)

U.S. banks are livid over the surcharge, and to add salt to the wound the Basel Committee said this month that the strength of a country's resolution regime cannot be taken into account when setting a company's surcharge.

In other words, U.S. banks will get no credit for Dodd-Frank's orderly liquidation authority or resolution plans.

"We are getting a capital surcharge premised on the Congress not having passed Dodd-Frank," said an executive at a large bank who thinks the surcharge should be closer to 25 basis points.

"U.S. regulators ought to stick up for us more," he said. "They ought to tell Basel: 'No U.S. bank is getting a surcharge until the rest of the world curbs the risk-taking of their banks like the U.S. has.' "

Beyond capital, by threatening to pull out of Basel, the U.S. could shift the international focus to something more important to us — a global agreement on how to unwind financial companies that operate across borders.

"The only area where I think it is absolutely vital to have a global framework … is cross-border resolution," Petrou said. "That is an area where the U.S. cannot go it alone. On capital, liquidity and prudential standards we can, and I increasingly think we should."

I ran this idea by a senior regulator involved in writing capital rules and it was clear he relished the prospect of washing his hands of Basel, but he suggested a middle ground: "We could square this circle by doing what we are going to do, and doing it in a form that looks Basel-ish, and just say, 'OK, we are there.' And everybody else would blink and agree with us.

"I think that's superior to pulling out of it or walking away from it. It's all a big mess, but it's our mess, and I think we are going to have to work it out and turn it into some rules that people can understand and live with."

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